China Will Maintain Manufacturing Supremacy

In the past three decades China has revolutionised global manufacturing. In that time 500 million people have moved from its fields to its cities, creating an unprecedented mass of factory workers. China's economy is changing, however, as wages rise and labour unrest grows. Does this mean an end to its dominance of global manufacturing? The Economist Intelligence Unit believes that new infrastructure and further productivity growth, allied to a continued supply of new urban workers, will keep China competitive, despite several new trends in supply chains.

China's huge supply of workers-its labour force will peak this year at around 802m-has been a boon for low-cost manufacturers, and has kept wages low. This, along with high levels of public investment in infrastructure, a stable political environment and respectable education, pushed China from the world's seventh-largest manufacturer in 1980 to displace the US as the world's biggest in 2010 when measured by the value of goods produced in US dollar terms. Inevitably, China's rise has been destabilising for existing manufacturing hubs. Some, such as South Korea, have been able to deftly move up the value chain, but others, such as South Africa and several economies in Central America, have seen their bases hollowed out.

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This success has brought increasing prosperity to China, and with it upward pressure on wages and working conditions. Unrest at factories in China run by a Taiwan electronics manufacturer, Foxconn, from 2010 began to erode confidence in China as the future of global manufacturing, generating speculation that producers of labour-intensive goods would go in search of cheaper destinations. The Economist Intelligence Unit believes that this story is overstated. By plotting our forecasts for labour productivity growth against nominal wage growth in a group of emerging economies in 2013-18, we discovered that there are few destinations that will become more cost-competitive than China, and none that will see their workers have a larger increase in productivity than those in China.

Lagging behind

Among Asian markets, Bangladesh is most frequently cited as an alternative to China for low-cost export manufacturing. Yet Bangladesh is forecast to make the least progress closing the competitiveness gap with China, with wages rising faster than in China but labour productivity growing only one-half as quickly. Vietnam has a similar rate of wage growth as China, but an appreciably slower rate of productivity growth. Indonesia is much the same, and given that it also scores below China in our business environment rankings (which evaluate the quality of domestic policies for potential investors), firms that move from China to Indonesia in the next several years are likely to do so for sector-specific reasons; for example, because they can make better use of Indonesia's less-skilled workers than other firms.

Most countries should see slower nominal wage growth than China in 2013-18. But among them only India can boast a labour force even approaching the size of China's, in an environment in which economies of scale are important. The Philippines, Peru, Poland and Taiwan are all expected to gain in wage-competitiveness vis-à-vis China, with productivity growth relatively fast compared with wage growth. Other emerging markets touted as rivals, such as Mexico, Brazil and Egypt, will experience only very small improvements in productivity.

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Wages are, of course, only one factor in relocation decisions. Production is also affected by the cost and availability of capital, infrastructure, inputs and the risks of operating in the market. We also mapped productivity growth against our score for operational risk. We consider most emerging markets to be riskier places to do business than China, most notably Argentina, Egypt and Nigeria. The cluster of those considered to be riskier and cheaper (and therefore of interest to firms willing to hedge the higher potential cost of risk against cheaper production) is smaller, and features India, Indonesia and the Philippines. The most desirable quadrant-those that are both less expensive and less risky-is populated only by Mexico, Peru, Poland and Taiwan.

Capricious consumers

Our analysis supports our existing view that low-cost manufacturers will not desert China en masse for other emerging markets in the coming years. But this does not mean that the dynamics of supply chains will remain static in 2014-18. We expect proximity to final markets to become an increasingly important factor because of shortening product life-cycles, a trend apparent across consumer goods segments, from clothing to technology. A shorter shelf-life creates a higher marginal benefit for firms that can ship from factory floor to shop shelves more quickly; for China, rising incomes mean that its manufacturers will focus increasingly on the domestic market. Growth in e-commerce will also put pressure on existing supply chains to provide a greater variety of goods to far-flung destinations quickly. These trends will favour economies with manufacturing capacity close to large or rapidly growing consumer markets, such as Mexico in Latin America, Poland on the fringe of Western Europe and China in Asia.

Environmental legislation may also alter the attractiveness of manufacturing destinations. In March 2014 the Chinese premier, Li Keqiang, said his government would "declare war" on pollution, initially by reducing polluting steel and cement production, and later by promoting green technologies. The prospect of a tax on carbon emissions in China is still remote (and is one of several options available to the government), but Mr Li's comments bring such legislation into view. Given the wide disparities in energy efficiency among emerging markets, such regulations could cause firms to reconsider the locations of their manufacturing hubs.

Local rivals

The most direct challenge to China's dominance of global manufacturing may come not from its many smaller competitors, each stealing a morsel of its market share, but from a behemoth on its doorstep. The Association of South-East Asian Nations (ASEAN) Economic Community (AEC), which is due to come into effect in 2015, aims to turn its ten South-east Asian member states into a single base for production and manufacturing and, eventually, a single market. On their own, Vietnam, Malaysia and even Thailand lack the economies of scale to compete with China. Collectively, however, the community will comprise more than 625m people, with a GDP of almost US$2.5trn. (Comparable figures for China are 1.3bn people and a GDP of US$10trn.) If the AEC is able to bring intra-country tariffs close to zero, value chains could be established that exploit the resources of its member states, from R&D in Singapore to capital-intensive manufacturing in Thailand to plentiful labour in Myanmar. And as the region will experience some of the world's fastest economic growth in 2014-18, the battle to supply goods to its burgeoning consumer markets will be intense.

Nevertheless, the most striking aspect of China's position at the centre of global manufacturing is its continued comparative advantage. In this respect, China will be strengthened by further improvements to its already impressive high-speed infrastructure and the depth of its industrial capacity in the coming years. And, despite government promises to crack down on the environmental cost of production, continued growth in China's urban population will ensure it remains a highly competitive location for a broad swathe of manufacturers.